A reserve currency is the foreign currency held as international exchange reserves by major financial institutions and central banks. Today, the U.S. dollar as a foreign reserve currency is the largest among the nations of the world. The drop in the U.S. currency exchange rates against the E.U.’s euro raises the question of whether the dollar will follow the historical lead of the U.K.’s pound in losing its status as the dominate international reserve currency among the world's nations.
Foreign Reserves Fuel the Market for Currenices
In an October 12, 2009 article "Dollar Reaches Breaking Point as Banks Shift Reserves," Bloomberg.com's Ye Xie and Anchalee Worrachate report that Barclays Capital data show a 63% second quarter 2009 increase in euro and yen foreign reserve investments. A U.S. Treasury Department report states that from the end of 1999 to second quarter 2008, foreign reserves in dollars fell from 71% to 62.5%, while euro holdings rose from 18% to 27%.
The E.U.'s euro was introduced in 1999 at a one to one parity with the U.S. dollar. By July 2008, one euro cost one dollar and fifty-seven cents. This suggests that a one dollar transaction received the equivalent of approximately an .64 cent price value in a dollar-euro exchange by the summer of 2008.
Central Banks Reduce Financial Risk Exposure Through Currency Diversification
India and China have eased up on U.S. treasury bond investments since June 2009. According to a November 3, 2009 Economic Times (ET) article "The Dollar Reserve Currency Conundrum" by U R Bhat, the two countries were among the nations feeling the need to diversify foreign exchange assets and increase gold reserves.
“The diversification is part of a secular trend which is a good trade-off between yield and safety,” said Hemant Mishr, MD, head-global markets, South Asia, Standard Chartered Bank, as reported by ET. Foreign reserve transactions among global central banks report reduced exposure to U.S. currency and an increase in diverse foreign currency assets.
In a July 15, 2009 article, the BBC News reported that China has the world’s largest foreign exchange reserves at more than $2 trillion, the bulk of which is in U.S. treasury bonds. A November 24, 2009 ET article, however, reports that China invested nearly $150 billion in U.S. treasuries between September 2008 and March 2009, but since April 2009 it has reduced its investments to about $30 billion.
Currency Diversification and the Rise of the Euro
Launched in January 1999, the euro has risen to become the second largest currency holding as foreign reserves. The euro now claims about a quarter of allocated foreign reserves.
As early as September 2007, Reuters reported that former U.S. Federal Reserve Chairman Alan Greenspan was quoted in a weekly German magazine Stern saying it was “absolutely conceivable that the euro will replace the dollar as the dominate foreign reserve currency, or will be traded as an equally important reserve currency.”
Econometric analysis by Jeffrey Frankel and Menzie Chinn also indicates that the euro could replace the U.S. dollar as the major reserve currency by 2020 if: (1) depreciation trend of the dollar persists into the future or (2) if E.U. members, such as the U.K., adopted the euro by 2020.
BRIC Nations Call for International Currency
While few currency analysts believe that the dollar will be replaced as the world’s dominant foreign exchange reserve anytime soon, calls among the so-called BRIC nations – Brazil, Russia, India, and China – for the establishment of an international currency suggests major changes ahead unless confidence in the value of the U.S. dollar stabilizes.
Russia has the world’s third-largest foreign reserves, about half of which are in dollars and the rest in euros and pounds. As reported by Gleb Bryanski for Reuters, Russia called for the dollar’s replacement as the world’s benchmark currency in 2009.
Joining in on Russia's call for an international currency, a week before the March 2009 G-20 global economic summit in London, governor of the People’s Bank of China, Zhou Xiaochuan, said a new currency reserve system controlled by the International Monetary Fund (IMF) would be more stable.
Value of the U.S. Dollar
A variety of factors are placing pressure on the value of the U.S. dollar as a safe haven asset, raising the question of whether there will be an eventual replacement of the U.S. dollar as the world’s top foreign reserve currency. If the euro or a so-called international currency replaces the dollar as the reserve currency, many analysts agree that the U.S. could face higher interest rates, increased taxes, and reduced economic growth for the long-term.
Additional References:
- The Euro Area and World Interest Rates by Jeffrey Frankel and Menzie Chinn, Janurary 4, 2005.
- Challenging the US Dollar’s Role as a Reserve Currency: Is the SDR a Credible Alternative? by Agnes M. Yap, Bangko Sentral ng Pilipinas Economic Newsletter, (No. 09-06) October 2009.
- "Worried Over Weak Dollar, India, China Cut US Debt Holdings" by Gayatri Nayak & Deeptha Rajkumar, Economic Times, November 24, 2009.
- "China Backs Talks on Dollar as Reserve - Russian Source" by Gleb Bryanski, Reuters, March 19, 2009.
Disclaimer: This article is for informational purposes only and should not be used as a substitute for tax or legal advice.
Vanessa Cross - Vanessa Cross is a freelance writer who writes about international trade, business law and small business development issues.
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